As I drive around town these days, I notice a lot of cars with temporary license plates indicating they were recently purchased. What’s the reason for this? When I turn on the TV, I see a commercial for a local car dealership. They are offering to accept your tax refund as the down payment on a new car. Now it starts to make sense.
The dealership knows consumers are about to receive an influx of cash and they want to make it as painless as possible to buy a new car. You the consumer view your tax refund as a bonus and a way to afford the car you’ve had your eye on the past few months. Furniture stores use the same strategy.
This type of financial behavior is known as mental accounting. Nobel Laureate Richard Thaler defined it as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.” In other words, mental accounting refers to how you assign funds to different categories based on their origin. The easiest example: people spend the money in their wallet differently than the money in their bank accounts.
We all use mental accounting in our daily lives. There’s nothing wrong with that. In fact, it can help you make good financial decisions. Or even better--avoid the big mistakes.
Here’s how I use mental accounting to improve my financial situation:
Reinvesting dividends. In the most rational sense, I should be viewing the dividends I receive from my investments the same way I view my wages. But I don’t give myself the option to spend the dividends. I reinvest them automatically, so I am purchasing shares throughout the year without any effort. This small step will help slowly increase my wealth over time.
Use windfalls thoughtfully. Individuals will typically use a windfall to purchase luxury goods, like the car example I gave above. I’m not going to claim that I’ve never spent a windfall on a luxury good that I normally wouldn’t buy. I am human after all. However, under normal circumstances I will try to take a thoughtful approach to using the windfall I’ve received. My favorite way to break it up is this: 25% goes to my emergency fund, 25% goes to my investment account, 25% goes toward a fun luxury, and 25% goes to charity. Depending on the amount, the percentages may vary slightly, but this is my target. With this approach, I can use money to maximize my happiness and my net worth.
Separate accounts for separate goals. My earned income goes directly into my checking account on a monthly basis. In the few days after it hits my checking account, I have automatic transfers setup to accomplish several goals. These include paying off my credit card in full, setting aside money for self-employment taxes, contributing to my Roth IRA, growing my emergency fund, and more. Each of these different accounts is a form of mental accounting. They help me keep my finances organized so I don’t make any big mistakes and continue to secure my future financial independence.